Transfer Pricing Regulations: A Comparative Study
Rajat Mittal & Adhitya Srinivasan, Students, NLIU, Bhopal
The authors have conducted deep research into how the transfer pricing regulations in India, OECD and other countries function and how effective it is in preventing the menace of transfer pricing manipulation. The authors have identified weaknesses in the law and made valuable suggestions on how it can be strengthened.
Transfer pricing has assumed enormous significance in the modern economic context. The practice of transfer pricing refers to the application of prices to transactions that are conducted within the precincts or structure of an enterprise. Over the years, most of these transactions have become unavoidable and fundamental to the economic survival of a transnational organization. However, an interesting dimension is thrown open when one considers the ability of a firm to drastically reduce its tax incidence by using transfer pricing. The mechanism by which this is put into effect is simple: prices for intra-firm transactions are fixed in such a manner that low profits are reflected in jurisdictions having a high tax rate while higher profits are shown in those jurisdictions having a low tax rate.
A sizeable portion of tangible and intangible global trade is intra-firm i.e. it is conducted within the enterprise itself.1 The OECD observer opines that as much as 60% of world trade takes place within multinational enterprises.2 This has at least two different implications. Firstly, a multinational corporation (hereinafter: MNC) may be subject to double taxation on the same profits. To put this into perspective, a survey conducted by PricewaterhouseCoopers on Tax Risks in India shows that transfer pricing has emerged as the most significant event for MNC firms leading to potential tax risk.3 Secondly, an MNC may use transfer pricing to reduce the overall tax burden by “trading” with production units or subsidiaries in different tax jurisdictions. The effect of these transfers is that governments are often deprived of revenue, and in some cases, the effect may be so severe as to trigger distortions in the Balance of Payments situation of a country.
It remains to be seen whether the understanding of associated enterprises as prescribed by Indian law is in sync with legal meanings given by other tax jurisdictions. This exercise has important ramifications with respect to clarity and consistency in law. To understand this better, consider a situation where one tax jurisdiction identifies an enterprise as a related party but another tax jurisdiction does not. MNCs are thus in a position to exploit the differential with the result that governments are faced with losses in revenue
Prior to the evolution of the arm’s length price (hereinafter: ALP), trade within an enterprise could subsist between two related units at an arbitrarily determined price. Consequently, governments, in an attempt to clamp down on tax avoidance, introduced the ALP principle to govern transfer pricing. To roughly restate the principle, under ALP, the transfer price is determined as if the two related units were independent and not a part of the same corporate structure.
The Government of India introduced law relating to transfer pricing for the first time by amending the Income Tax Act, 1961 (hereinafter: ITA) through the Finance Act, 2001. The amended Act included sections 92 to 92F as part of Chapter 10 related to Special Provisions Relating to Avoidance of Tax. Additionally, the Organization for Economic Co-operation and Development (hereinafter: OECD) has revised a set of guidelines related to transfer pricing in 2009.
This research paper attempts to understand the confluence and conflict between India, the OECD and other countries by studying guidelines and legislations with regards to transfer pricing regulations. In view of the stated consideration, this paper seeks to study the functioning of the law and its effort in preventing the menace of transfer pricing manipulation. Ultimately, the paper proceeds to question the need for change in the law and if so, the areas that require change. To briefly outline the structure of this paper, the concept of associated enterprises is first discussed, followed by a study of the scope of international transactions. Further, the paper explains the notion of ALP and its various methods of computation. The paper then proceeds to survey the documentation standards required under different jurisdictions. Finally the paper suggests improvements in the legal framework and concludes.
II. Associated Enterprises
The understanding of associated enterprises is critical to transfer pricing regulation. Quite clearly, any legislation or regulation related to transfer pricing would operate only insofar as transactions take place between parties or enterprises that come within the legal meaning of related parties i.e. associated enterprises. Consequently, the principle of ALP would apply only between two parties who are associated enterprises. This in turn bears consequences on tax planning of enterprises and revenue collection of governments.
Implications of Associated Enterprises under Indian Law
The Memorandum of the Finance Bill, 2001 seeks to provide a statutory framework which can lead to the computation of reasonable, fair and equitable profits and tax in India.4 Further, the Central Board for Direct Taxes (hereinafter: CBDT) issued a circular with regards to the transfer pricing legislation stating that the provisions have been enacted with a view to ensure that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions leading to erosion of our tax revenues.
the ITA functions in a manner such that, subject to s. 92B (2), only transactions between associated enterprises fall within the regulations contained in Chapter X. As per the law, at least one of the parties requires to be a non-resident i.e. if the parties to a transaction can prove that they are both residents, they would be saved from the application of arm’s length pricing …
The amended ITA seeks to identify and regulate intra-firm transactions so as to not to lose government revenue. To achieve this, s. 92A of the ITA, 1961 accords an extensive definition to Associated Enterprises. As per the statute, it includes an enterprise which participates in the management or control or capital of another enterprise.6 Furthermore, the statute provides thirteen specific instances wherein two enterprises will be deemed to be associated enterprises. These instances include voting power, loan value, total borrowings, appointment of the Board or governing council, dependence on intellectual property of an enterprise, supply of raw materials and consumables, selling rights on products, controlling authority or mutual interest.7 Moreover, clause (iii) of s. 92F describes “enterprise” to mean a person (including the permanent establishment of such person) who is, or is proposed to be, engaged in any activity related to, inter alia, production, distribution, supply or control or articles or goods, or intellectual property or provision of services of which [another] enterprise is the owner or has exclusive rights.
The Hon’ble Supreme Court held in DIT (International Taxation) vs. Morgan Stanley & Co8 that where the staff of Morgan Stanley & Co were sent on deputation to one of its captive BPO unit in India, and the staff continued to be directly employed by Morgan Stanley, a Service Permanent Establishment existed between the BPO unit and the parent unit i.e. Morgan Stanley and Co. In this regard, the case of Sony Entertainment Television Satellite (Singapore) Pvt. Ltd. vs. DDIT9 bears significance. The ratio of the judgment delivered by the Bombay High Court is that the income of a nonresident carrying on business in India through a dependent agent, remunerated at arm’s length, having a permanent establishment in India will not be liable to tax unless such income is directly or indirectly attributable to that of the permanent establishment.
Pursuant to this, any transaction (as defined under s. 92F(v)10 of the ITA, 1961) taking place between two enterprises who are associated enterprises within the descriptions ascribed by the law, shall be governed by transfer pricing laws included in Chapter X and shall be taxed accordingly.
Comparative analysis of different jurisdictions
It remains to be seen whether the understanding of associated enterprises as prescribed by Indian law is in sync with legal meanings given by other tax jurisdictions. This exercise has important ramifications with respect to clarity and consistency in law. To understand this better, consider a situation where one tax jurisdiction identifies an enterprise as a related party but another tax jurisdiction does not. MNCs are thus in a position to exploit the differential with the result that governments are faced with losses in revenue. The purpose of this section therefore is to evaluate the definition of related parties under different jurisdictions against the meaning of associated enterprises under the ITA, 1961.
The OECD Model Convention on Tax, 2005 forms the basis of most tax treaties. It has been adopted by most OECD members and some non- OECD members as well. As part of the Convention, Article 9 gives meaning to Associated Enterprises. Article 9 identifies Associated Enterprises on the basis of participation in management, control or capital of an enterprise of a contracting State.11 Further the Article provides for an appropriate adjustment to be made by a contracting State in the event of double taxation i.e. where profits have been taxed in two contracting States but would have accrued to the enterprise of only one of these contracting States had the two enterprises been independent.12
It may be well to understand how transfer pricing regulations work to identify related parties in other jurisdictions. Under some jurisdictions, the law governing transfer pricing identifies associated enterprises in a manner similar to Indian law. In the United Kingdom for instance, Schedule 28AA of the Income and Corporation Taxes Act, 1988 (hereinafter: ICTA) provides that arm’s length pricing would apply where a provision has been made or imposed between two connected persons by means of a transaction or a series of transactions and one person participates in the management, control or capital of the other at the time of making or imposing the provision.13 Similarly, in Canada, s. 251(2) of the Income Tax Act defines related persons.14 However, s. 252(1)(a) provides that the law shall presume that related parties are not dealing at arm’s length.15 The consequence of this provision is that Canadian law does not give regard to how related parties conduct their mutual business transactions. In Russia, Article 20 of the Russian Tax Code gives legal meaning to related parties by describing three situations of which the first has contextual bearing.16 Under Russian law, two parties are related if one party holds greater than 20% equity participation in the other party. Furthermore, under Article 20.2, Russian courts can recognize parties to be related if the relation between such parties could have some bearing on the outcome of the transaction.17
In another set of jurisdictions, the emphasis shifts away from associated enterprises to the nature of the transaction between two parties. Take for instance the case of Australia where Division 13 of the Income Tax Assessment Act, 1936 (hereinafter: ITAA) applies to non arm’s length dealing under an international agreement. 18 There is no specification with regards to the relation between parties. Under s. 136AD of the ITAA, if the Commissioner is satisfied that parties to an international transaction are not dealing at arm’s length prices, the law shall presume that consideration at arm’s length has been received or is receivable by the taxpayer. 19 A similar situation is prevalent in the United States where transfer pricing is governed by s. 482 of the Treasury Regulations.20 As per s. 1.482-1(a)(1), the purpose of the section is to ensure that taxpayers clearly reflect income attributable to controlled transactions by placing a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.21 The Treasury Regulations do not define related party and the provisions may be construed so as to give significance to the nature of the transaction.
Regardless of definition, the law across jurisdictions must function so as to govern a wide range of transactions and to prevent transfer pricing manipulation. If associated enterprise forms the critical element for transfer pricing laws, then care must be taken by tax administrations to ensure that the implications of the same are consistent with that of other jurisdictions. An important question arises (and will subsequently be addressed) as to the utility and efficacy of beginning an analysis of transfer pricing regulations with associated enterprises.
III. International Transaction
Transfer pricing regulation firstly identifies the relationship between parties that would be governed by the ALP i.e. associated enterprises. Having extensively discussed the nature of parties which would be under the scanner of the law, it proceeds to describe the nature of the transactions conducted between related parties that would be subject to ALP. Stated differently, arm’s length pricing would administrate only those transactions between associated enterprises which have been described by the law.
Connotations of international transaction under Indian law
The ITA, 1961 functions on two tiers and will impose arm’s length pricing only on certain transactions i.e. international transactions between certain parties i.e. associated enterprises. The reasoning behind introducing ss. 92 to 92F by amending the ITA in 2001 is briefly explained by a circular released by the CBDT.22 According to the circular, the new provisions apply to a wider set of transactions including payment of royalty and other individual transactions that do not constitute a part of the regular business carried on between a resident and a non-resident. Furthermore, the new provisions prescribe the documentation required to be maintained by the taxpayer.23 Such provisions did not exist in the previous editions of Chapter X of the Act.
S. 92B of the ITA, 1961 gives legal meaning to international transaction. In order to fully understand the ambit of international transaction, it becomes important to consider the definition of transaction as given under s. 92F(v).24 As per the s. 92B, international transaction refers to a transaction between two associated enterprises, both or either of whom are non-residents,25 that includes the purchase, sale or lease of intellectual property, provision of services, lending or borrowing of money, or any transaction that has a bearing on the profits, incomes, assets and losses of the enterprise. Further, an international transaction shall include any mutual agreement between associated enterprise with regards to the allocation or apportionment of, or contribution to, any cost or expense incurred in relation to any benefit, service or facility to be provided by either of the enterprises.26
Additionally, as part of the statutory framework governing income tax, the transfer pricing law shall deem certain transactions to be international transactions. Where the transaction is entered into between parties who are not associated enterprises within the meaning of the law, it will be deemed to be a transaction entered into between two associated enterprises if there exists a prior agreement in relation to the relevant transaction or the terms of the relevant transaction are determined in substance by the two parties.27
Based on a perusal of s. 92B read with (r/w) s. 92F (v) of the ITA, it is amply clear that the legal definition of international transaction is extremely wide and inclusive, sufficient to capture all kinds of transactions between associated enterprises. However, the ITA functions in a manner such that, subject to s. 92B (2), only transactions between associated enterprises fall within the regulations contained in Chapter X. As per the law, at least one of the parties requires to be a non-resident i.e. if the parties to a transaction can prove that they are both residents, they would be saved from the application of arm’s length pricing.
Cross-jurisdictional connotations of transaction
Transaction between parties constitutes the critical element for the functioning of transfer pricing law. As with the case of associated enterprises, it is imperative to ensure consistency and clarity in law across tax jurisdictions. Failure to do so causes the emergence of a differential, liable to be exploited by transnational firms. Consider the case where a particular transaction comes within the purview of transfer pricing regulation under one jurisdiction but not under a second jurisdiction. Enterprises would be tempted to conduct transaction through parties situated in the second jurisdiction culminating in the accrual of revenue losses to the first jurisdiction.
The prevailing consensus is to impose arm’s length pricing by comparing transaction taking place between two related enterprises with similar transactions taking place between two non-related enterprises. While the OECD Model Convention on Tax does not specifically address the concept of transaction, when Article 7 (relating to business profits) is read with (r/w) Article 9 (relating to associated enterprises), it may be deduced that transactions resulting in profits to business enterprises would fall within the tax net.28
The experience is that some countries choose to impose transfer pricing regulations solely on the basis of international transactions without going into the definition of related parties. Take for instance the case in Australia where according to Division 13 of the ITAA, 1936 applies to all transactions resulting from an international agreement between parties.29 Further in the United Kingdom, transfer pricing regulation is set into motion where a condition is made or imposed by a transaction or a series of transactions between related parties.30 In the United States, s. 482 of the Treasury Regulation lays emphasis on the nature of the transaction.31
The definition of international transaction is significant. Consequently, the scope of an international transaction i.e. the nature and extent of transactions has a direct bearing on whether the transaction would fall within the realm of transfer pricing regulations or not. To understand this further, under certain jurisdictions, tax authorities focus their attention on transactions within certain industries. For instance, the Canada Revenue Agency (hereinafter: CRA) tends to include transactions in the automobile, banking and consumer products industry under its transfer pricing audits. As with the case of associated enterprises, it is fundamental to consistency and certainty, that the implications of international transaction are the same across jurisdictions. It may be well to explore the possibility of applying international transaction as a trigger in transfer pricing regulations i.e. to impose ALP solely on the basis of international transaction. Amidst the other considerations of time, costs and general efficacy, it is important to consider the increase in revenue and the reduction in litigation costs by going ahead with this proposal.
IV. Arm’s length price (ALP)
The purpose of ALP is to prevent tax evasion. ALP functions so as to price transactions between two associated enterprises as if the transaction was taking place between two non-related enterprises. It may not be possible to accurately recreate the effect of market forces of demand and supply into a transaction between related parties however transfer pricing legislation makes an effort to artificially import the same. While tax administrations may be misinformed in presuming that every transaction between associated enterprises is undertaken to minimize or evade tax, it is important, regardless of any contractual obligations between related parties to make adjustments and approximate the ALP with respect to transactions.
It would be well to briefly understand some of the challenges facing the application of ALP before proceeding to discuss the computations methods. Some of these are stated under the 2009 OECD Transfer Pricing Guidelines. For instance, the various associated enterprises that function within the framework of an MNC are largely autonomous. They often bargain with each other as if they were truly independent enterprises.32 Even so, hard bargaining may not constitute evidence of dealing at arm’s length. A further problem arises owing to the cash flow requirements prescribed by MNCs.33 Moreover, the enterprises may engage in transaction that independent entities do not engage in. Under such circumstances, the transaction cannot be compared with any other market transaction. Another set of problems arise because of conflicting governmental pressure. Transaction between associated enterprises may be subject to varying custom valuations, anti-dumping duties, pricing controls, etc.34
Computation of ALP under Indian law
Most tax jurisdictions statutorily prescribe various methods that may be employed for the purposes of computation of ALP and applying it to the concerned transaction. Prior to the amendment of the ITA, the earlier s. 92 r/w Rule 11 of the Income Tax Rules, 1962 (hereinafter: ITR) provided for an adjustment in the profits of an enterprise if it appeared to the Assessing Officer that the course of business between the resident and non-resident was arranged in such a manner as to result in less than expected profits to the resident, owing to the close connection between the two. The circular issued by the CBDT explaining the reasoning behind the amendment states that the earlier provision was limited in scope.35 It did not allow adjustment in income in the case of non-residents. The term “close connection” was undefined and construed vaguely. Further, it provided for the adjustment of profits rather than adjustment of prices.36
At the very outset, the revised s. 92(1) of the ITA provides that income arising from an international transaction (including allowance for any expense or interest) shall be computed at ALP. The definition clause applying to the transfer pricing provisions describes ALP as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.37
Section 92C describes the various methods to compute the ALP. As per s. 92C (1), the ALP in relation to an international transaction shall be determined by the most appropriate method among the methods prescribed i.e. comparable uncontrolled method, resale price method, cost plus method, profit split method, transactional net margin method or such other method prescribed by the Board, having regard to the nature of the transaction or class of transaction or class of associated persons or functions performed by such persons or other relevant factors prescribed by the Board. The law is subject to two conditions – firstly, where the application of the most appropriate method results in more than one price, the ALP shall be calculated as a mean of the prices and secondly, where the variation between the ALP and the price of the international transaction does not exceed 5% of the latter, the latter price will be deemed to be the ALP.38
Factors affecting the selection of the most appropriate method
In determining the most appropriate method to be employed in the computation of ALP under s. 92C, regard must be had to Rule 10B and 10C of the ITR which prescribe the manner of application of the aforementioned methods and the factors to be taken into account while selecting the most reliable measure of ALP respectively. Accordingly, the ITR prescribes that the method examines the nature and class of the international transaction, class or classes of associated enterprises entering into the transaction, the availability, coverage and reliability of data necessary for application of the method, the degree of comparability39 existing between the international transaction and the uncontrolled transaction,40 the extent to which reliable and accurate adjustments can be made to account for differences and the nature, extent and reliability of assumptions required to be made in the application of the method.41
However, it is important to perform a detailed transfer pricing analysis of the specific characteristics of an international transaction so as to correctly determine the ALP. Accordingly, the Income Tax Appellate Tribunal (Delhi) in Mentor Graphics (Noida) (P) Ltd. vs. Dy. CIT,42 while disregarding the revisions of the Transfer Pricing Officer (TPO) held that it has to be prima facie shown that the transaction was properly examined and comparable prices objectively fixed. In an important judicial development, paving the way for clarity in the Indian transfer pricing laws, the Appellate Tribunal (Kolkatta) held in Development Consultants Pvt. Ltd. vs. Dy CIT43 that in the pursuit for the most appropriate method, it is necessary to first select the ‘tested party’44 which will be the least complex of the controlled taxpayers engaged in the transaction and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.
Traditional Transaction Methods
The Traditional Transaction Methods include the comparable uncontrolled price method (hereinafter: CUPM), the resale price method (hereinafter: RPM) and the cost plus method (hereinafter: CPM). Under the CUPM, determination of ALP requires the identification of the price of property transferred or service provided in a comparable uncontrolled transaction or a series of such transactions. Following this, prices are to be adjusted for differences (if any) with the prices in international transactions.45 Under the RPM, the price at which property obtained from an associated enterprise is resold or services provided by an associated enterprise are provided to an independent entity is taken as the base price. The normal gross profit margin which could be earned by an enterprise in the same or similar uncontrollable transaction as well as any expenses incurred in connection with the purchase of property or services are deducted from the base price. The price arrived at is adjusted to take into account the functional and other differences with the international transaction prices.46 The CPM may be considered a reversal of the RPM. Here, the direct and indirect costs incurred in respect of the property transferred or service provided to an associated enterprise is determined. Further, a normal gross profits margin reflecting a same or similar uncontrolled comparable transaction is added. The price arrived at is adjusted to factor functional and other differences with the price of the international transaction price.47
Transactional Profit Methods
The Transactional Profits Methods include the Profit Split Method (hereinafter: PSM) and the Transactional Net Margin Method (hereinafter: TNMM). Under the PSM, the combined net profits of all the associated enterprises arising from an international transaction are calculated and then divided among the associated enterprises on the basis of relative contribution of each of the enterprises with regards to functions performed, assets employed and risk assumed. This data is weighed against reliable external market data which indicates how such contributions would be evaluated by unrelated entities partaking in an international transaction. The ALP is computed as against the profits apportioned to the various associated enterprises.48 The TNMM is accorded the status of being the method of the last resort. Under this method, the net margin of an international transaction is computed in relation to costs incurred, sales effected or assets employed or any other base. Further, the net margin realized by the enterprise or unrelated enterprise on an uncontrolled comparable transaction is computed with respect to the same base and adjusted to account for differences between the international transaction and the uncontrolled comparable transaction.49
The OECD Transfer Pricing Guidelines 2009
Member countries of the OECD are of the consistent view that ALP should govern the evaluation of transfer prices among associated enterprises for the simple reason that the arm’s length principle is sound on theory and provides the closest approximation to the workings of the open market with regards to transactions between related entities.50 This consistency serves to achieve the object of securing the appropriate tax base in each jurisdiction and avoiding double taxation.51
As per the OECD Guidelines, the ALP is computed and applied to transactions by comparing the conditions of a controlled transaction with those of independent transactions.52 As per the Guidelines, the various factors that must be considered while assessing the comparability of a transaction include the specific characteristics of the property or services,53 the functions that each enterprise performs (including assets used and risks undertaken),54 contractual terms,55 economic circumstances of different markets56 and business strategies.57
Hierarchical preference of ALP computation methods
While the OECD guidelines provide for both traditional and profit methods for the computation of ALP, they have historically favoured the former over the latter.58 Accordingly, CUPM, RPM and CPM have enjoyed hierarchical precedence over PSM and TNMM. The transactional profit methods were accorded the status of being methods of the last resort and member countries were advised to use it only where data compiled from the application of traditional transactional methods were inappropriate or unreliable.59
The proposed revisions to the 2009 Guidelines seek to remove this hierarchical construction of the computation methods. In other words, no longer do the traditional methods assume preference over the profit methods. Chapter 2 of the OECD Guidelines addresses the relationship of the traditional methods with other methods and states that while traditional methods are the most direct means of establishing whether conditions in the commercial and financial relations between associated enterprises are at arm’s length, the complexities of real life business situations may put practical difficulties in the application of the traditional methods.60 This new approach has been built on experience since the Guidelines were released in 1995. The proposed revisions acknowledge that certain facts and circumstances may be better assessed using transactional methods.61 It incorporates commentary from the January 2009 Discussion Draft which on transactional profit method which departs from the hierarchy of methods. However, the proposed revisions do not discuss the CUPM in this context so it may be understood that the CUPM retains its status as being the method of choice.62
Cross Jurisdictional Analysis
The computation of ALP bears significant policy consequences. It therefore becomes important to survey computation methods and investigate consistency across different tax jurisdictions. Under the United States Transfer Pricing regulations, a taxpayer must select one of the pricing methods specified in the regulation to test the arm’s length character of its transfer pricing. Under the Best Method Rule, the pricing method selected must provide the most reliable measure63 of an arm’s length result, regard being had to the facts and circumstances of the transaction. Further, the US regulations are flexible in that the taxpayer is saved from any adjustment so long as his transfer pricing results fall within an arm’s length range derived from two or more comparable uncontrolled transactions.64 In Australia, arm’s length transfer pricing methodologies for international dealings was put into effect by means of Taxation Ruling 97/20 (hereinafter: TR 97/20) of the Australian Taxation Office. As per TR 97/20, it shall apply to international dealings with retrospective effect save for any conflict with the terms of settlement prior to the ruling.65 Australia’s transfer pricing rules do not prescribe any particular methodology or any preference for the order in which methodologies may be applied at arriving at the arm’s length outcome.66 While Australian law does not preclude any methodology as long as it is consistent with the statutory objective,67 TR 97/20 states that OECD guidelines are to be used in applying methodologies. Under Canadian law, statutory rules on transfer pricing were introduced with effect from 1997. Canadian transfer pricing legislation is largely consistent with OECD Guidelines i.e. statutory rules require that transactions between related parties be carried out at arm’s length terms and conditions. The law does not contain any specific guidelines to measure arm’s length, instead, the law functions in a manner so as to leave scope for the application of judgment. The CRA recognizes both traditional methods viz. CUPM, RPM, CPM and profit methods viz. PSM and TNMM. A circular issued by the CRA, outlining administrative guidance, states that the CRA shall examine the application of the method selected by the taxpayer to ensure that the selected method produces the most reliable measure of an arm’s length result.68 In the United Kingdom, Schedule 28AA which was introduced with effect from April 2004 puts the onus on UK taxpayers to self assess their compliance with the arm’s length principle. While introducing the amendment to the ICAA, one of the stated objectives of the government was to bring the UK transfer pricing legislation in line with the OECD Guidelines.69
V. Issues relating to record keeping
The matter of record keeping is significant in that the enforceability of the transfer pricing regulations is directly related to it. In a sense the various records or documents that are required to be maintained by an enterprise constitute evidence for the purposes of law as to whether or not the enterprise has been indulging in transfer pricing manipulation in the realm of international transactions. Failure to comply with the requirements of maintenance would lead to the invitation of penalties.
Transfer pricing regulations have been introduced across tax jurisdictions knowing full well that tax administrations would face an inherent challenge. This challenge may be understood as the need to balance the ultimate objective of achieving a high degree of compliance with the statutory and regulatory framework in the various countries in which an MNC is operating on the one hand and the management of the level of taxes being paid on a global basis in a competitive environment. Clearly, the issues related to maintenance of records are not limited to tax administrations. They greatly affect the tax planning exercises of MNCs. In an adversarial system where the taxpayer and the taxation authority are seen to be at loggerheads with each other, there is little scope for a “play safe” strategy. Consequently, no degree of conservatism adopted by an enterprise in its transfer pricing policy and procedure will save it from taxation authorities.
From the perspective of tax administrations, it is expected that enterprises are in a position to support their tax returns and demonstrate that their transactions have not been subject to transfer pricing manipulation. Differently stated, enterprises must be able to documentarily establish that all their international transactions have been conducted in conformity to the arm’s length principle. Accordingly, most of the world’s major trading nations have evolved detailed requirements for the documentation of transfer pricing matters.
Documentation Requirements in India
Under Indian law, s. 92D of the amended ITA provides for the maintenance and keeping of information and documents by persons entering into an international transaction. Furthermore, s. 92E provides that the report of an accountant is to be furnished by persons entering into an international transaction. As per s. 92D, all persons entering into international transactions are required to maintain the prescribed information and documents.70 Further, the CBDT is competent to prescribe the time period for which the prescribed information and documents are to be maintained.71 Furthermore, in the course of any proceeding under the ITA, the Assessing Officer (hereinafter: AO) or the Commissioner (Appeals) may require that prescribed information be furnished in respect of any international transaction by any of the parties thereto within a period of thirty days of being served a notice to that effect.72
The ITR prescribes the various documents that must be maintained by persons who enter into international transactions. As per Rule 10D (1), the necessary documents are mentioned.73 However, Rule 10D (2) further states that where the books of account of the assessee enterprise show that the aggregate value of the international transactions entered into by it does not exceed one crore rupees, the assessee would not be required to maintain information and documents as prescribed under sub-section (1). This clause operates provided that the assessee would be able to substantiate in material particulars that the income accruing to him through international transactions is in accordance with s. 92 of the ITA. The ITR also specifies what documents would be considered to be authentic for the purpose of maintaining records and includes official publications, studies, reports of market analyses carried out by technical publications, published accounts and financial statements of the business group and its associated enterprise, etc.74 Further the ITR also specifies that the documentation produced under sub-section (1) and (2) must be contemporaneous and should exist latest by the date specified under s. 92F (iv)75 as well as the time period for which the information and documentation must be maintained under this Rule i.e. eight years after the relevant assessment year.76 In Cargill India Pvt. Ltd. v Dy. Commissioner of Income-Tax,77 the Income Tax Appellate Tribunal (Delhi) imposed penalties on a taxpayer for failure to comply with the regulations prescribed under s. 92D r/w Rule 10D relating to maintenance of documents. Further the Tribunal held that the taxpayer and tax authority, depending on the facts and circumstances of the case are required to consider relevant information needed for determining the ALP. In Cusherman & Wakefield (S) Private Ltd. v. Dy CIT, the Authority for Advanced Rulings ruled that the Indian subsidiary of a U.S. Company committed a default when it was late in providing transfer pricing documents to the government.
The statutory framework also prescribes that a report from an accountant is to be furnished by persons entering into international transactions. As per s. 92E, every person who enters into an international transaction during a previous year shall obtain a report on or before the specified date in the prescribed form, duly signed and verified in the prescribed manner.78 Further, the ITR prescribes that the report from the accountant required to be furnished under s. 92E of the ITA shall be in Form No. 3CEB and verified in the manner indicated therein.79
Documentation Standards under the OECD Guidelines
The 2009 Guidelines released by the OECD provides extensive literature on Documentation required to enforce transfer pricing regulation. The documentation required varied across jurisdictions. For instance, in those jurisdictions where the tax administration bears the burden of proof, it is not the onus of the taxpayer to establish the correctness of its transfer pricing. The OECD Guidelines encourage taxpayers to maintain documentation regardless of burden and jurisdiction.80 Accordingly, the Guidelines state that it would be reasonable to expect taxpayers to prepare or obtain information with regards to the nature of activity when establishing the transfer pricing for a particular business activity. Furthermore, the Guidelines also caution tax administration to balance its need for documentation with the costs and administrative burden to the taxpayer of creating or obtaining the same. Other guidelines in this respect also state that tax administrations should limit requests for documents to those that become available after relevant transactions, tax administrations should require only those documents which are in the actual possession of taxpayers, etc.81 With regards to specific documents, the OECD Guidelines state that it is useful to refer to information pertaining to an outline of the business, the structure of the organization, ownership linkages with the MNC group, the amount of sales and operating margins in the years preceding the transaction, the level of taxpayer’s transactions with foreign associated enterprises,82 etc.83 In addition to this information, the OECD Guidelines also suggest that it may be useful to procure information relating to factors that influenced the establishment of any pricing policy within an MNC, management strategy, general commercial and industry conditions affecting the taxpayer, possibility of risk and documents showing the process of negotiations culminating in the determination or revision of prices in controlled transactions.84
VI. Suggestions for improvement
This portion of the paper will focus on the reforms required in the Indian law to better serve the object of increasing revenue by preventing transfer price manipulation. Indian tax law as hitherto discussed in this paper was restricted to the law for the time being in force i.e. the Income Tax Act, 1961. In the 2009-10 Budget, the Finance Minister of India announced that there would be a new Direct Taxes Code.85 When the DTC comes into effect, it would amend parts of the law relating to transfer pricing in India. The purpose behind discussing the DTC under this section is to consider the present Indian law and the future Indian law and then determine the requirement for improvement.
Eliminating the statutory usage of Associated Enterprise
Under the DTC, the amount of any income or expense arising from an international transaction shall be determined having regard to the ALP.86 Both the ITA and the proposed DTC begin their analysis of transfer pricing through associated enterprise i.e. the law functions in a manner which investigates whether arm’s length dealing has been applied in an international transaction between two associated enterprises. Thus in the eyes of the law, associated enterprises forms the critical base from which transfer pricing manipulation comes into effect. In other words, the ambit of the law will extend only to those entities which come within the meaning of associated enterprises. The DTC contains a dedicated Chapter for the purpose of preventing evasion of tax.87
It is not doubted that the DTC has enlarged the scope of associated enterprises. The interpretation clause provided in this chapter defines associated enterprise.88 Whereas the ITA demanded one enterprise to hold 26% voting power, the DTC requires only 10%; whereas the ITA required a loan advanced by one enterprise to constitute at least 51% of the book value of the assets of the other enterprise, the DTC places the figure at 26%; where the ITA needed one enterprise to appoint half of the members of the Board or governing council, the DTC pegs the figure at one- third; and whereas the ITA requires that 90% of raw materials and consumables are supplied by one enterprise to another, the corresponding figure in the DTC is two-thirds. Based on these facts, it may be concluded that a larger number of entities and consequently a larger number of transactions would be governed by transfer pricing laws.
However, there is always the possibility of the scope of associated enterprise being so narrow as to not cover a particular set of enterprises. Subsequently, transfer pricing between these enterprises would not come under regulation and the purpose of preventing tax evasion is defeated. The problem lies in that both the current law and the proposed DTC require that the relationship between two entities must fall within the thirteen specific illustrations. In principle, we therefore suggest the elimination of usage in respect of associated enterprise in the law relating to transfer pricing.
Enlarging the scope of international transaction
As per the previous segment, the statutory usage of associated enterprise would be scrapped from the transfer pricing regulations. Subsequently, the foundation for determining arm’s length dealing insofar as the law is concerned would be shifted to international transaction. It therefore becomes important to define international transaction in the widest possible sense and give it the widest possible ambit. Both the ITA and the DTC define international transaction as a transaction between two or more associated enterprises for the purchase or sale or lease of tangible or intangible property, supply of service, borrowing money, mutual agreement between two associated enterprises, etc.89 Furthermore, both statutes provide that certain transactions will be deemed to be international transactions if there exists a prior agreement between parties with respect to the terms of the transaction.90 Thus, the scope of international transaction is wide. Additionally, there was some uncertainty with regards to the parties to an international transaction under the prevailing Indian law. Under s. 92B (2), where certain transactions are deemed to be international transactions, there is no specification as to whether either of the parties must be non-residents or not. However, this confusion has been cleared by the DTC. Under the current and proposed statutory language, the meaning of international transaction is founded upon the concept of associated enterprise. It is our suggestion that the where the law reads “a transaction between two or more associated enterprises”, it should read “a transaction between two parties either or all of whom is a non-resident including a permanent establishment of the nonresident”. This change would bring Indian law in sync with Division 13 under the Australian ITAA and would significantly increase the coverage of transactions. After premising the law on international transactions, the tax authorities may mull the option of subjecting a specific set of industries (which in their opinion indulge in transfer pricing manipulation) to transfer pricing audits as is the case with the CRA. In this manner, a potent mechanism is instituted to check evasive practices.
Computation of ALP and the Advance Pricing Agreement
The earlier ITA did not make any provision for an Advance Pricing Agreement (hereinafter: APA). However the DTC has introduced an APA clause.91 Under the DTC, the Board, with prior approval of the Central Government, may enter into an APA with any person in respect of ALP in relation to an international transaction which may be entered into by that person on the basis of the prescribed method being the most appropriate for a period of five consecutive financial years. Further it provides that the ALP for such transactions shall be determined in the manner provided in ss. 106(1) – (4) of the DTC.92 We endorse this change as a forerunner of greater certainty and consistency in the law relating to transfer pricing in India. Both the taxpayers and tax authorities are aware of the price agreement. Consequently, the benefits of administrative convenience accrue to both parties.
Clarity on comparability
At present, while the Indian law provides for making adjustments for differences between prices in controlled international transactions and those in uncontrolled transactions, there is no guidance or clarity as to how these adjustments are to be made.93 In contrast, the US Transfer Pricing Guidelines lay down that if there exist material differences between the prices of controlled and uncontrolled transactions, adjustments must be made to the uncontrolled transactions so that the arm’s length range is derived only from those uncontrolled transactions which have or after adjustments can be brought to a similar level of reliability and comparability.94 Specifying guidelines with respect to the manner in which adjustments are to be made would greatly alleviate taxpayers’ burden.
At this juncture, a detailed analysis has been presented on transfer pricing regulations across jurisdictions. The primary purpose of these regulations is to cut down on evasion of tax and subsequently increase revenue reserves. It is true that transfer pricing is often considered by tax authorities as a soft target with huge potential to produce large increases in revenue.95 Towards this end, various countries evolved regulations to govern transfer pricing in their respective jurisdictions. The important questions posed during the course of the preceding paragraphs were whether the incumbent legal framework is effective in view of its stated purpose and whether the legal framework is consistent with similar statutory compilations in other jurisdictions.
Most legal dispensations identify associated enterprises, transactions between associated enterprises and then seek to determine whether these transactions have been conducted at the ALP. We suggested that analysis begin from international transactions for the sole reason that the ambit of transfer pricing regulations would be widened. Further, under a cross-jurisdictional comparison, the meaning of associated enterprises or related parties may vary. With a view to ensure consistency, it would help if transfer pricing analysis began from the stage of international transactions. Additionally, we were in favour of the APA for firms so as to further strengthen the objects of consistency and certainty. The DTC proposal in this regard would also bring the Indian law in sync with the OECD Guidelines.96 Finally, we endorsed the need for greater clarity in the realm of comparability i.e. in determining how adjustments between an international transaction and an uncontrolled transaction are to be made.
With an incessant annual surge in intra-firm transactions, transfer pricing regulations can only acquire greater, not lesser attention. The tax authorities were right in identifying transfer pricing as a soft target yielding high returns in terms of augmenting governing revenue. However, the conversion of soft targets into high yields requires the critical element of an effective, sensitive legal mechanism. While we elaborately discussed statutory provisions across jurisdictions during the course of this paper, we also laid emphasis on the implications of these provisions so as to ascertain their efficacy. In view of the various considerations asserted in this paper, we believe that the legal framework pertaining to transfer pricing must incorporate provisions to efficiently increase revenue by nullifying scope for evasion and to ensure cross- jurisdictional consistency.
* Adhitya Srinivasan (Student II year at National Law Institute University, Bhopal) and Rajat Mittal (Student V year at National Law Institute University, Bhopal). Contact No: +919617647827. Contact Email: firstname.lastname@example.org. Postal Address: Room A-217, Boys’ Hostel, National Law Institute University, Kerva Dam Road, Bhopal 462044, M.P.
1 Pieter J. “Developments with regards to the OECD Transfer Pricing Guidelines.” (2001). United Nations Public Administration Network. Available online at: .[Last visited on 8 October 2009 ]
2 Neighbour, John. “Transfer Pricing: Keepin it arm’s length.” OECD Observor. Jan. 2002. Oct. 2009. Available online at . [Last visited on 7 October 2009]
3 The survey conducted in 2007 found that transfer pricing issues with setting up business outside India and different interpretations of the Indian tax authorities are key instances leading to potential tax risk situations.
4 Memorandum of Finance Bill, 2001. “Measure to curb tax avoidance – New legislation to curb tax avoidance by abuse of transfer pricing”. Available online at . [Last visited on 9 October 2009
5 See Circular no. 12 dated 23.8.2001 issued by the CBDT.
6 See s. 92A(1) of the ITA, 1961.
7 See s. 92A(2) of the ITA, 1961.
8 DIT (International Taxation) v Morgan Stanley & Co. Inc. & Morgan Stanley & Co. Inc. v Director of Income Tax (Mumbai). (2007) 7 SCC 1.
9 (2008) 110 BOMLR 2726.
10 The amended ITA defines transaction to include an arrangement, understanding or action in concert, whether or the same is formal or in writing and whether or not the same is intended to be legally enforceable.
11 See Article 9(1) of Articles of the Model Convention with respect to taxes on income and on capital, 2005 (OECD Model Convention on Tax)
12 See Article 9(2) of the OECD Model Convention on Tax.
13 Fletcher, Richard, and Steven Cawdron. “UK: What you should know about intangibles and UK Tax.” International Tax Review (2009).
14 “Transfer Pricing Country Profiles: Canada.” Organisation for Economic Co-operation and Development.12 Oct. 2009. http://www.oecd.org/dataoecd/20/20/39424177.pdf [Last visited on 10 October 2009
16 “Transfer Pricing Country Profiles.” Organisation for Economic Co-operation and Development. . Last visited 12 October 2009
18 “Transfer Pricing Country Profiles.” Organisation for Economic Co-operation and Development. . Last Visited 12 October 2009
20 “APA and Transfer Pricing Published Guidance.” Internal Revenue Service. Web. . Last Visited on 13 October 2009.
22 See Circular no. 14/2001 dated 12.12.2001 issued by the CBDT.
24 Supra Note 8.
25 See s. 6 of the ITA, 1961.
26 See s. 92B(1) of the amended ITA.
27 See s. 92B(2) of the amended ITA.
28 “OECD releases final Report on the Attribution of Profits to Permanent Establishments.” Organisation for Economic Co-operation and Development.. . Last Visited on 15 Oct. 2009
29 Under Australian law, it is presumed that consideration received or receivable by the taxpayer is at arm’s length price if the parties to an international agreement are not dealing at arm’s length.
30 See Schedule 28AA of the ICTA, 1988.
31 Under the Treasury Regulations, a controlled transaction would meet the arm’s length standard if the results of the transactions are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.
32 Chapter I – The Arm’s Length Principle. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 2009 Edition. Paris: OECD, 2009.
33 Consider a case where a publicly held MNC is under constant pressure to reflect high profitability at the parent company level.
35 Supra Note 20.
37 See s. 92F (ii) of the ITA.
38 See s. 92C(2) of the ITA.
39 See Rule 10B (2) of the ITR which prescribes grounds according to which the comparability of an international transaction is to be judged.
40 See Rule 10B (3) of the ITR which states the grounds upon which an uncontrollable transaction shall be comparable with an international transaction.
41 See Rule 10C (2) of the ITR.
42  109 ITD 101 (Delhi).
43 (2008) 115 TTJ (Kol) 577.
44 The concept of ‘tested party’ has not been explained in Indian legislation. Under s. 1.482-5 of the US Treasury Regulations, “the tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable data”.
45 See Rule 10B (1)(a) of the ITR.
46 See Rule 10B (1)(b) of the ITR.
47 See Rule 10B (1)(c) of the ITR.
48 See Rule 10B (1)(d) of the ITR.
49 See Rule 10B (1)(e) of the ITR.
50 Supra Note 30.
52 International Transfer Pricing 2009. 2009 Edition. PricewaterhouseCoopers LLP, 2009.
53 Characteristics that may be considered include in the case of tangible property, the physical features of the property, its quality and reliability and the availability and volume and supply, in the case of services, the nature and extent of the services, and in the case of intangible property, the form of transaction, the degree and duration of protection, etc.
54 The functions that taxpayers and tax administrations might need to identify and compare include design, manufacturing, R & D, servicing, purchasing, distribution, etc. Particular emphasis must be paid to the structure and organization of the group.
55 The contractual terms of a transaction generally define explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the parties.
56 Economic circumstances that may be relevant to determining market comparability include the geographical location, size of the markets, extent of market competition and relative competitive position of the buyers and sellers.
57 Business strategies would factor certain aspects related to enterprises such as innovation and new product development, degree of diversification, risk aversion, assessment of political changes, input of existing and planned labour laws, etc.
58 “OECD proposes to Fine-tune Transfer Pricing Guidelines – TaxNewsFlash-Canada 2006-17.” KPMG in Canada. Web. 16 Oct. 2009.
60 Chapter II – Traditional Transaction Methods. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 2009 Edition. Paris: OECD, 2009.
61 Supra Note 53.
63 Reliability is judged on the use of comparable uncontrolled transaction and the degree of comparability between these transactions and the transactions of the taxpayer as well as on the completeness and accuracy of the underlying data, the assumptions made and the adjustments required to prove comparability.
64 Supra Note 47.
65 “TR 97/20 – Income tax: arm’s length transfer pricing methodologies for international dealings (As at 5 November 1997).” 17 Oct. 2009.
73 The documents required to be maintained include inter alia a description of the ownership structure of the assessee enterprise, a profile of the multinational group of which the assessee enterprise is a part including the tax residence of all enterprises which partake in international transactions, a broad description of the business of the assessee and the industry in which it operates, the nature and terms of the international transaction including the details and value of property transferred and services provided, a description of the functions performed, risks assumed and assets employed by the assessee and the associated enterprise, a record of any market analysis or financial estimates for the entire business group and any of its enterprises which may influence the terms of an international transaction, a record of uncontrolled transactions taken into account for the purpose of comparability, a record of the analysis performed to evaluate comparability, a description of the methods used for determining ALP, and any assumptions, policies or price negotiations which have influenced the determination of ALP.
74 See Rule 10D (3) of the ITR.
75 See Rule 10D (4) of the ITR.
76 See Rule 10D (5) of the ITR.
77  300 ITR 223 (Delhi).
78 See s. 92E of the ITA.
79 See Rule 10E of the ITR.
80 Chapter V – Documentation. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 2009 Edition. Paris: OECD, 2009.
82 This includes the amount of sales on inventory assets, rent of tangible assets, interest on loans, use and transfer of intangible assets, etc.
83 Supra Note 74.
85 The new Code is proposed to be applicable w. e. f 1st April, 2011.
86 See s. 105(1) of the DTC.
87 See Chapter IX – Special Provisions to prevent Evasion.
88 See s. 113(5) of the DTC.
89 See s. 113(15) of the DTC.
91 See s. 107 of the DTC.
92 These sections relate to Computation of arm’s length price.
93 Phatarphekar, Rohan. “The Hindu Business Line : Transfer pricing – keeping issues at arm’s length.” The Hindu Business Line: Tuesday, October 20, 2009. 21 Feb. 2008. Web.. . [Last visited on 18 Oct. 2009]
95 Supra Note 47.
VIII. References Statutory References
• Articles of the Model Convention with respect to taxes on income and on capital, 2005 (OECD Model Convention on Tax)
• Memorandum of Finance Bill, 2001. “Measure to curb tax avoidance – New legislation to curb tax avoidance by abuse of transfer pricing”.
• Circular no. 14/2001 dated 12.12.2001 issued by the CBDT.
• “Transfer Pricing Country Profiles” Organisation for Economic Co-operation and Development.12 Oct. 2009. ”TR 97/20 – Income tax: arm’s length transfer pricing methodologies for international dealings (As at 5 November 1997).” 17 Oct. 2009. .
• CRA Information Circular (IC 87 – 2R) at paragraphs 47 – 63.
• Tax Risks in India – Survey Conducted by Pricewaterhouse Coopers LLP
• OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 2009 Edition. Paris: OECD, 2009.
• International Transfer Pricing 2009. 2009 Edition. PricewaterhouseCoopers LLP, 2009. Articles
• Pieter J. “Developments with regards to the OECD Transfer Pricing Guidelines.” (2001). United Nations Public Administration Network. .
• Neighbour, John. “Transfer Pricing: Keepin it arm’s length.” OECD Observor. Jan. 2002. Oct. 2009.
• “APA and Transfer Pricing Published Guidance.” Internal Revenue Service. Web. 13 Oct. 2009.
• “OECD proposes to Fine-tune Transfer Pricing Guidelines – TaxNewsFlash-Canada 2006-17.”
KPMG in Canada. Web. 16 Oct. 2009. .
• “OECD releases final Report on the Attribution of Profits to Permanent Establishments.” Organisation for Economic Co-operation and Development.15 Oct. 2009. .
• Fletcher, Richard, and Steven Cawdron. “UK: What you should know about intangibles and UK Tax.” International Tax Review (2009).
• Phatarphekar, Rohan. “The Hindu Business Line : Transfer pricing – keeping issues at arm’s length.” The Hindu Business Line : Tuesday, October 20, 2009. 21 Feb. 2008. Web. 18 Oct. 2009. .
96 Chapter IV – Administrative Approaches. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 2009 Edition. Paris: OECD, 2009.
[Editorial Note: 2nd Best Research Paper of 5th Nani Palkhivala Research Paper Competition for the year 2009. Reproduced with permission from the AIFTP Journal]